Economic Models Must Account for ‘Who Has the Power’

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Nobel Prize winning economist Joseph Stiglitz recently highlighted two schools of thought on how income is distributed to different groups of people in the economy. Which school is correct has important implications for our understanding of the forces that have caused the rise in inequality, and for the policies needed to reverse this trend. It also relates to another controversy that has flamed up recently, how economics should be taught in principles of economics courses.

The first school of thought is that inequality is a natural and equitable outcome of competitive market forces. According to this view, which is based upon textbook models of competitive markets, individuals are rewarded according to their contributions to the economic well being of society. Those who contribute the most to the production of the goods and services we all enjoy receive the highest rewards and climb to the top of the income distribution.

For workers, the reward depends upon their human capital, the skills and talents they bring to the marketplace. For capitalists, it depends upon the amount of financial resources they are willing to risk in an attempt to bring new products to market, or improve upon those that already exist. Thus, the study of inequality has traditionally focused on how human and physical capital are distributed in society, and how that distribution changes over time.

This school of thought attributes the rise in inequality to two sources, technological change that has enhanced the ability of skilled workers to contribute to the social good, and globalization that has made it possible to satisfy the needs of larger and larger numbers of people all over the world. Since those at the top of the income distribution are being equitably rewarded for their contributions to society, any attempt by government to intervene and reduce inequality through income redistribution will undercut the incentives the market offers for contributing so much.

For this reason, this school argues that instead of interfering with the efficiency and fundamental equity the market system brings us, what is needed is to elevate the skills of the have-nots through education to improve their human capital, and to ensure that everyone has equal opportunity to reap the rewards the market system has to offer.

The second view of inequality, one that is gaining traction, emphasizes market imperfections and the exploitation of power relationships. Adherents to this school of thought believe that market systems have an inherent tendency toward large monopolies, and this tendency has been furthered by technological change, globalization, and economic strategies by incumbent firms that make it hard for new competitors to enter the market.

As monopoly power becomes established, those with economic and political power can capture the political process and prevent the enforcement of antitrust law and regulatory change that could threaten their market dominance. The political power large firms have can also be used to undermine unions destroying any chance workers have to bargain on equal footing for wages. This leads to even higher profits and more inequality.

The solution in this case is for government to get involved rather than step away. The outcome is no longer has the efficiency properties that come with a competitive market system, and the claim that the distribution of income is equitable in the sense of being based upon an individual’s contribution to society rather than the exploitation of economic and political power is lost. As Professor Stiglitz says:

“In today’s economy, many sectors – telecoms, cable TV, digital branches from social media to Internet search, health insurance, pharmaceuticals, agro-business, and many more – cannot be understood through the lens of competition. In these sectors, what competition exists is oligopolistic, not the ‘pure’ competition depicted in textbooks. … If markets are fundamentally efficient and fair, there is little that even the best of governments could do to improve matters. But if markets are based on exploitation, the rationale for laissez-faire disappears. Indeed, in that case, the battle against entrenched power is not only a battle for democracy; it is also a battle for efficiency and shared prosperity.”

If the view that we cannot fully explain the evolution of the economy with traditional models is correct, and I believe it is, it has important implications for the recent debateover howeconomics shouldbe taught. There is much to be said for teaching the traditional model of perfect competition in principles of economics courses. For one, it provides a baseline for measuring how far market imperfections push us away from an efficient and equitable outcome and it provides a goal for policymakers to strive for as they try to implement solutions to these problems. It also provides students with an important framework to think about the costs and benefits of economic choices. For example, if we want to reduce fraud in the financial sector, at what point does the cost of an additional regulator or other preventative measure exceed the benefits?

These courses do spend time looking at the economic consequences of monopolistic completion, oligopolies, and monopolies, though not enough in most cases. But students are left with the impression that these market structures are aberrations from the norm rather than the normal state of affairs. That needs to change. And what is missing altogether in most cases is a discussion of power relationships. Quoting Professor Stiglitz once again, “historically, the oppression of large groups – slaves, women, and minorities of various types – are obvious instances where inequalities are the result of power relationships, not marginal returns.”

If we want students to come away from these courses fully equipped to understand issues such as those that have fueled the rise of Donald Trump and Bernie Sanders, and to be able to evaluate the merits of the solutions they have proposed, discussions of the power relationships that come with departures from pure competition must be a central part of the education they receive.

University of Oregon macroeconomist Mark Thoma writes primarily about monetary policy its effect on the economy. He has also worked on political business cycle models. Thoma blogs daily at Economist’s View.